Key Points
Companies that generate plenty of free cash flow can reward investors with dividends.
McDonald's uses a franchise model that is conducive to cash flow generation.
Despite operating in a cyclical industry, Home Depot has raised dividends for many years.
It's crucial for a company to produce earnings growth. That should translate into cash flow. Companies can use that operating cash flow for capital expenditures to invest in the business's long-term growth. What's leftover is free cash flow (FCF). If companies have ample FCF, they can reward investors by paying dividends.
Of course, investors need to pick companies that have strong long-term business fundamentals and sustainable FCF. McDonald's (NYSE: MCD) and Home Depot (NYSE: HD) certainly qualify. Here's why you should them now.
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1. McDonald's
Many people around the world recognize McDonald's famous golden arches. Its business model and how the company makes money isn't as well known, however.
The company ended the second quarter with over 46,000 restaurants, but 95% were operated under a franchise agreement. It has a couple of different arrangements, but the key point is that the franchisee pays the operating costs and necessary capital expenditures. This asset-light business allows McDonald's to collect an up-front fee, an ongoing licensing fee (percentage of sales), and, in certain cases where it owns the property, rent.
Fortunately, sales have been growing, benefiting McDonald's. Its second-quarter same-store sales (comps) increased 1.3%. With its franchise model, higher sales, and improved profitability, McDonald's generates plenty of FCF. For the first half of the year, it had FCF of $3.7 billion. That gives it plenty of cushion to afford the $2.6 billion in dividend payments.
Historically, the company has shown a strong commitment to raising dividends. Last month, the board of directors announced it would boost the December quarterly payout by 3.8% to $1.93. That marked 50 straight years of increases, meaning that McDonald's joined the ranks of the Dividend Kings. That's an impressive group of companies with at least 50 consecutive years of dividend hikes.
At the new $1.93 rate, the company will pay an annualized dividend of $7.72 per share. That equates to a 3.2% dividend yield. That's more than triple the S&P 500 index's 1%.
2. Home Depot
Home Depot isn't merely a home-improvement retailer. By offering attractive prices and convenience, it's the dominant company in the sector, with the highest sales. Although the company's results fluctuate with the economic cycle, they are also affected by key factors, including home sales, consumer confidence, unemployment, and inflation. These impact homeowners' ability and willingness to undertake major construction projects.
There's no denying that macroeconomic conditions have been challenging. Existing home sales fell 2.5% and 2.2% year over year in both August and September, according to data released by the National Association of Realtors.
Meanwhile, mortgage rates have spiked, with the average 30-year fixed rate at 7.4% for the week ended Oct. 15. This makes it more expensive for borrowers to purchase homes, and will likely continue to dent home-buying demand.
Large economic factors have certainly affected Home Depot's sales as homeowners have pushed off major renovations. Its sales have been tepid. That includes Home Depot's fiscal second-quarter sales, with comps increasing only 1.7%. Still, its adjusted diluted earnings per share grew 5.1% versus a year ago to $4.92. The results were for the period that ended on Aug. 2.
Home Depot produced more than enough FCF to pay dividends. For the first half of the year, it had FCF of $9.7 billion compared to $4.6 billion in dividends.
Despite its results being influenced by economic forces outside of its control, Home Depot has built a remarkable record of dividend increases. It has raised them every year starting in 2010. Even during the challenging years of the Great Recession, Home Depot kept dividends constant from 2007 through 2009.
Home Depot's stock has a 3% dividend yield, three times that of the S&P 500 index.
Lawrence Rothman, CFA has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Home Depot. The Motley Fool recommends the following options: long January 2028 $320 calls on McDonald's and short January 2028 $340 calls on McDonald's. The Motley Fool has a disclosure policy.